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\fCHAPTER 3 Finding and Evaluating the Right Property Whether you are buying a principal residence or investment property, you want to make money on resale and avoid problems and expenses during the interim. Ideally, you want to buy low and sell high. You also want to minimize stress and inconvenience, and maximize tax-free or after-tax profit. There is a good prospect of doing so if you follow the guidelines outlined in this chapter and the rest of the book. This chapter will explain the main factors to consider when selecting a property, where to find a property for sale, and how to determine its value. Helpful Web sites will also be included. Factors to Consider When Selecting a Property There are many factors to consider when selecting real estate for use as a principal residence or for investment purposes. In general, a combination of factors will determine your decision to buy in a particular area. It is important to make a final assessment based on an objective review of the realistic investment potential, taking into account the various factors. This section discusses where to get general and specific real estate information, and the types of issues to consider. Refer to Checklist 1 in the Appendix for an outline of many of the factors you should consider and compare in properties that interest you. Where to Get General Information Part of your research to enhance the quality of your decision making is to have a general overview of trends and economic factors that might affect your choice and/or location of investment. There are many sources of information, depending on your available time, personal priorities, and the amount of effort you are willing to expend. The saying that \"knowledge is power\" is an accurate one. The more general and specific information you have, the better the chance you will 70 Chapter 3 have of making the right decision and being aware of opportunities. Here are some sources of general economic and real estate information you may wish to consider. Remember, as discussed in Chapter 1, each market is unique, so general trends may or may not have a direct bearing, but they will give indications. Other factors in your specific geographic area will influence demand and prices. National Newspapers There are two main publicationsThe Globe and Mail and The National Postthat deal with financial and economic issues and trends, as well as regular features and reports on real estate. Consider subscribing to them. Remember, the subscription fee is a 100% tax-deductible expense against any income from your business or investment. Regional and Local Business or Real Estate Newspapers Check with your local newsstand or public library to find out which publications are relevant to your needs. Some publications are free. Courses and Seminars These provide another way to increase your awareness and enhance your decision making. There are real estate as well as general business management courses offered from time to time by the school board and college adulteducation programs. Also, practical courses for the general public are offered on home buying, home building and renovating, by homebuilder industry associations and the Canadian Mortgage and Housing Corporation. Check out the CMHC site at www.cmhc-schl.gc.ca. Check out the Web site for the Canadian Homebuilders' Association at www.chba.ca to find out contact information for provincial or local homebuilder association seminars or courses. Books Check out your local library and bookstore for books on real estate investing, responsibilities of a landlord, and related topics. Also check the Web sites of Chapters/Indigo at www.chapters.ca, and Amazon Books at www.amazon.ca. Trade Shows Local home shows or renovation shows, where you can pick up ideas and contacts and attend seminars, are excellent sources of information. Finding and Evaluating the Right Property 71 Where to Get Specific Information The following sources of information will provide helpful assistance or more specific research steps. (Refer to Chapter 1: Understanding Real Estate Investment for further information.) Internet The Internet is a valuable research tool. You can find out almost anything you want to know about real estate by using effective search techniques. Google is one of the best search engines currently available (www.google.cw). Other relevant Web sites of interest are mentioned throughout this chapter. Statistics Canada This federal government department can provide you with invaluable information relating to population movements, general trends, census data, socio-economic profiles, and other demographic data. Contact your local library for Statistics Canada research data and analysis, or contact Statistics Canada directly. Look in the Blue Pages of your telephone directory under \"Government of Canada,\" or reach them through their Web site at www.statcan.ca. Canada Mortgage and Housing Corporation (CMHC) This federal Crown corporation compiles invaluable historical data, analysis of information, and housing trends and projections, among other things. It has superb sources of information, and can provide personalized research consulting services for a fee if you want to know specialized information about a specific area. Many of the publications are free and available upon request or found on their Web site. Other publications are available at market cost. You may want to contact CMHC and ask them to put you on their mailing or e-mail list. To contact the CMHC branch office nearest you, look in the Blue Pages of your phone book, or check out their Web site at www.cmhc-schl.gc.ca. Some of the many CMHC publications available include the following analyses and reports. Obtain a current list of publications: The Housing Market Outlook (semi-annual) covers projections of market activity in communities with a population of 100,000 or more Rental Market Reports (annual) for all areas with a population of 100,000 or more. Also stats available for communities of 10,000 or more Chapter 3 72 Local Housing Now (monthly) covers new and resale home stats for the same type of community populations as noted above. National Housing Observer (annual) for new and re-sale homes. Real Estate Survey of House Prices Royal LePage publishes a quarterly Survey of Canadian House Prices. It is free of charge and can be picked up at a local Royal LePage office, or is available through their Web site at www.royallepage.ca. This survey is invaluable and provides information on current (as of survey) estimated \"fair market value\" house prices, prices three months earlier and one year earlier, and percent change year-over-year. Estimated average taxes and average monthly rentals are also indicated. Four different categories of single-family housing are surveyed, together with a standard and luxury condominium high-rise apartment. Each housing type and its amenities are specifically described, permitting comparisons of value across the country. This includes many regional construction variances for which adjustments have been applied. Naturally, the quality of location has a major influence on real estate values. The properties surveyed are deemed to be within average commuting distance to the city centre and are typical of other housing in the neighbourhood. The survey will also give you an idea of price and rental trends in a particular location. National Real Estate Firms All of the major national real estate firms have Web sites with valuable research information available on properties. Check in the Yellow Pages of your phone book for real estate company names and Web sites, or check on the Internet for the Web site address by doing a www.google.ca search. Real Estate Boards Most boards keep statistics on historical prices in their geographic area. A real estate agent can provide you with helpful data. If the real estate board operates on a Multiple Listing Service (MLS), there will be even more data available through a member realtor or on the MLS Web site (www.mls.ca). Real Estate Agents Agents are a vital source of information about housing in the geographic area of interest that you are considering. (How to select and effectively use an agent Finding and Evaluating the Right Property 73 is covered in Chapter 4: Selecting Your Advisory Team.) A real estate agent can locate a great deal of information for you through the MLS system, such as price comparisons, historical data and trends, listing profile of property, and more. You can also do your research on the www. mls.ca site. Municipal Planning Department This department should be able to advise you if there is a development planned in the community of interest to you. This could include apartment buildings, condominium complexes, shopping centres, or highway expansions, for example. You could also enquire if there is any potential rezoning that might affect the property you are considering. Check to see if there have been any natural disasters such as flooding or mudslides that could affect your property. Also, find out how many building permits have been issued. Which areas have the greatest new construction and renovation activities? If you are interested in applying for rezoning, building a new house, or renovating an old house, ask for the following material as your circumstances dictate: zoning maps, zoning regulations, building codes, building permit application forms and instructions, municipal codes, and regional master plans. Economic Development Department This department is normally associated with the municipality or regional district. Its function is to stimulate economic activity and employment in the area. The department should have information about long-term growth plans that will have a positive economic impact on the community. This would include the locations of the growth. Purchasing a residential property near a future growth area could enhance your financial return, e.g., near locations of rapid transport, subways, major shopping mall or office development. Municipal Tax Department Find out the basis on which property taxes are calculated. Your municipality might have a high commercial tax base, which effectively subsidizes the residential tax base, thereby keeping residential taxes down. Maybe your municipality is growing rapidly and is becoming, in effect, a bedroom community with lots of families. If the supply of schools and teachers in the municipality is low and the demand is increasing, property taxes could go up to finance the construction of schools and the hiring of teachers. 74 Chapter 3 If you are buying for retirement purposes, you may not want to pay property taxes for services you will not use immediately. Check to see if there are any major property tax increases planned in general and why, and specifically for the property you are considering. In the latter case, a new drainage system or lane paving could be passed on directly to the property owners affected. Municipal Police Department Check with the local police department for statistics related to crime in the neighbourhood you are considering. Compare the crime rate with other communities. Determine if it is increasing or decreasing. Municipal Fire Department Ask the fire department about the frequency of fires in the neighbourhood you are considering, relative to other areas in the general community. If there are a high number of fires, the neighbourhood could be a risk area, especially if arson is suspected. Also ask about the incidence of false alarms in the neighbourhood you are considering. This also gives an indication of potential problems. Local Newspapers These can be an excellent source of information on issues affecting the community in general or a specific location in particular. You can pick up back issues over the past few months from the newspaper office or check with the local library. Local Homebuilders' Association The community you are considering may have a Homebuilders' Association. Look in the Yellow Pages or check out the Web site for the Canadian Homebuilders' Association at www.chba.ca. You can obtain contact information about provincial or local Homebuilders' Associations through the site. The association members could tell you which areas of the community have high growth and the trends that indicate future high growth. Remodelling Contractors Look in the phone book for contractors who specialize in remodelling. Contact at least three contractors and ask which areas of the community appear to have a high percentage of remodelled homes, which can add value to the property you purchase because they improve the overall attractiveness of the neighbourhood. Finding and Evaluating the Right Property 75 Building or Home Inspector Check with local private building or home inspectors. You can find them in the Yellow Pages or contact the Canadian Association of Home and Property Inspectors through their Web site www.cahpi.ca. Ask them which areas of the community are expanding; which areas have had a lot of remodelling done; which areas have problems such as drainage, insects, etc.; and which areas have resale homes in excellent condition. Neighbours Don't forget to ask the people in the area you are considering how they enjoy the neighbourhood. Would they buy there again? Which specific features about the neighbourhood do they like or dislike? What is the ratio of owners vs. renters? Ask for feedback that gives you some feeling for the quality and stability of the community. Whether you are thinking of buying a principal residence or an investment property, these issues are important for peace of mind as well as resale potential. Important Factors to Consider Some of the general features and factors are discussed below. Certain factors might be more important if you are buying for personal use (principal residence) rather than as a revenue real estate investment. Remember to refer to Checklist 1 in the Appendix when you are making your selection. Location One of the prime considerations is the location. How close is the property to schools, cultural attractions, shopping centres, recreational facilities, work, and transportation? How attractive is the present and future development of the area surrounding the property? You could invest in a property and six months later a high-rise complex could be built across from you, blocking your view and therefore decreasing the resale value of your property. The location should have ample access to parking and other attractive features. Check on the amount of traffic on the streets in your area. Heavy traffic can be a noise nuisance as well as a hazard for young children. Noise Thoroughly assess the level of noise. Consider such factors as the location of highways, driveways, parking lots, playgrounds, and businesses relative to the 76 Chapter 3 property you are considering. If you are buying a condominium, also consider the location of the garage doors, elevators, garbage chutes, and the heating and air conditioning plant or equipment. Privacy Privacy is an important consideration and has to be thoroughly assessed. For example, ensure that the sound insulation between the walls, floors, and ceilings of your property is sufficient to enable you to live comfortably without annoying your neighbours or having your neighbours annoy you. If you have a condominium or townhouse unit, such factors as the distance between your unit and other common areas, including walkways, roads, and fences, are important. Price The price of the property you are considering should be competitive with that of other, similar offerings. On the other hand, if you are purchasing a condominium unit, it is sometimes difficult to compare prices accurately without taking into account the different amenitiessuch as tennis courts, swimming pool, recreation centre, etc.that may be available in one condominium but not available in another. You may decide that you do not want these extra facilities in view of your lifestyle needs, in which case paying an extra price for the unit because of these features would not be attractive. On the other hand, you have to look at the resale potential, so check with your realtor. He or she can obtain accurate information on comparative pricing and cost per square foot for similar properties. Common Elements and Facilities If you are buying a condominium unit, review all the common elements that make up the condominium development. Are they relevant to your needs? What are the maintenance or operating costs that might be required to service these features? Parking Facilities Is the parking outdoors or underground? Is there sufficient lighting for security protection? Is it a long distance from the parking spot to your home? Is there parking space available for a boat, trailer, or second car, and is there ample visitor parking? Finding and Evaluating the Right Property 77 Storage Facilities Check out the type of storage space available, including its location and size. Is there sufficient storage space for your needs, or will you have to rent a minilocker to store excess items? Quality of Construction Materials Look thoroughly at your building and the surrounding development to assess the overall quality of the development. If you are buying a condominium, keep in mind that you are responsible for paying a portion of the maintenance costs for the common elements. You may wish to hire a contractor or building inspector whom you trust to give you an opinion on the quality and condition of the construction before committing yourself. An older building will obviously cost money to repair, possibly a considerable amount of money and in a short time. Design and Layout When looking at a building, consider your present and future needs. For example, if you are buying a condominium, although you are entitled to use the interior of your unit as you wish, there are restrictions relating to the exterior of your unit or any structural changes that you may make to the unit. If you intend to add a separate room for an expanded family, in-laws, or an office, if that is possible, you should consider the implications beforehand. For example, you may find that the balcony is very windy and you would like to build a solarium to enclose the balcony for that reason. There is a very good chance that you would not be able to do so without the consent of the condominium council because it would affect the exterior appearance of the development. Neighbours Look at the surrounding neighbourhood and determine whether the value of the residences in the neighbourhood will affect the value of your property. For example, are the homes in the area well maintained? Are there children in the same age group as your own children? What sort of people live in the neighbourhood? Are they single adults, young couples (with or without children), or older retired people? 78 Chapter 3 Owner-Occupiers vs. Tenants If you are buying a condominium, ask how many tenants as opposed to owners there are or will be in the condominium complex, and the maximum number of tenants allowed. The higher the percentage of owner-occupiers, the better the chance that there will be more pride of ownership and therefore more responsible treatment of common elements and amenities. If you are purchasing a house, the same principle applies. Generally you should be concerned if the tenant percentage in the condominium complex or residential area is 25% or more and is increasing. Management If you are buying a condominium unit or apartment building, find out whether the building is being operated by a professional management company, a resident manager, or if it is self-managed. (This is discussed in more detail in Chapter 10: Managing Your Property.) Ideally, you should check out the condominium unit or property that you are interested in at three different times before you decide to purchase: during the day, in the evening, and on the weekend. That should give you a better idea of noise level, children, or parties, and the effectiveness of the management control. Property Taxes Compare the costs of taxes in the area that you are considering with those of other areas equally attractive to you. Different municipalities have different tax rates and there could be a considerable cost saving or expense. Also, find out if there is any anticipated tax increase and why. Rental Situation in the Area If you are thinking of purchasing a revenue property, look for an area that enjoys a high rental demand. You want to minimize the risk of having a vacancy. Check Royal LePage's Survey of Canadian House Prices, referred to earlier, to obtain average house rentals in the area. Their site is www.royallepage.ca. On the other hand, you don't want too many rental houses, as that will increase competition and possibly reduce the overall desirability of the neighbourhood. Also, check the CMHC rental stats in the area that interests you. Their Web site is www.cmhc-schl.gc.ca. Finding and Evaluating the Right Property 79 Local Restrictions and Opportunities Check if there are restrictions on use and other matters. For example, is there a community plan? What type of bylaw zoning is there, and is it changing? Is there a rezoning potential for higher or different use? Is there a land-use contract? What about non-conforming use of older or revenue buildings? Perception of the Area What perception does the media or the public in general have about a certain area? Is it positive or negative, and why? People's perception of the area may influence rental or purchase decisions. Stage of Development A geographic area will typically go through a series of stages, phases, and plateaus over time. For example, the normal stages are development (growth), stabilization (maturing, plateauing), conversions (from apartments to condos), improvements of existing properties, decline of improvements (deterioration), and redevelopment (tearing down of older buildings and new construction, with more efficient use of space). Economic Climate This is a major factor to consider. What is stimulating the economy, not only in terms of renters but actual homebuyers? Is there new development such as shopping centres, house and condo construction, office buildings, franchise outlets, and other commercial activity? Will the provincial or federal government construct or move offices to the community? Is a major single-industry employer the main source of economic activity in the area? In the latter case, you can appreciate the risk involved if the industry or main employer has financial problems or decides to close down or move away. Conversely, in many major cities of Canada, the commercial rent in downtown areas is high and the commuting time and/or downtown residential rents or house prices inhibit employee retention. For this reason, many companies are moving their operations to the suburbs, where commuting, rent, and land costs are cheaper, and employee retention is higher. 80 Chapter 3 Employment This factor is, of course, related to the economic climate. The closer the tenants live to their workplace, the lower the turnover will be. The closer the workplace to the employee, the higher the demand will be if you sell your property. Population Trends Look for the trends in the community you are considering. Are people moving in or out, and why? What is the average age? Type of employment? Income level? Family size? Ethnic origins? Marital status? Many of these demographic statistics can be obtained from Statistics Canada or from your provincial or municipal government. If the population is increasing, it will generally create more demand for rental and resale housing. Conversely, if it is decreasing, the opposite will occur. If the population is older, people may prefer downsizing to condominiums rather than buying smaller houses. There are many variables to consider. Size and Shape of Lot This factor has to do with subdivision or rezoning potential, resale marketability, and general enjoyment. Transportation A prospective tenant or homebuyer will want to have convenient transportation routes. Whether it's a bus, subway, rapid transit, freeway, ferry, or other mode of transportation, the quality of transportation will have a bearing on your rental or resale price. Topography The layout of the land is an important consideration. If the property is lowlying (i.e., adjacent to a rise or hill), water drainage problems could result. Water could collect under the foundation of the house, thereby causing settling, assuming there is only soil under the foundation. Maintaining the property in terms of cutting the grass could be more difficult if the ground is uneven rather than level. These are just some of the issues to consider. Appearance Look at the appearance of the property you are interested in. Would it be attractive to someone else if it is resold? Is it well maintained, or does it need repair? What do the other buildings in the neighbourhood look like? Are they Finding and Evaluating the Right Property 81 new, renovated, or attractive? Or are they poorly maintained with peeling paint, uncut grass, broken windows, and trash lying about? Crime Rate Naturally, this is an important issue for purchase or sale. How to obtain this information was covered in an earlier part of this chapter. Services in the Community Different services available in the communityfor example, shopping, churches, community and recreational facilities, playgrounds or parks, and schoolswill attract different types of tenants or purchasers, depending on their needs. Climate If you are buying for personal use and eventual resale or buying as an investment, climate is an important consideration. Certain areas of the city or community may have more rain, snow, and wind than others, depending on historical climate patterns. Unattractive Features Look for factors that will have a negative influence on a prospective tenant or purchaser: unpleasant odours from an industrial plant, a lack of natural light for the home because of overgrown trees, lack of street lighting that impairs safety, inadequate municipal services such as septic tanks rather than sewer facilities, unrepaired roads, or open drainage ditches. Awareness of these negative factors will also assist you in your decision making and negotiating approach. (This is covered in more detail in Chapter 9: Negotiating Strategies.) Convenient Proximity If you are buying real estate as an investment, it is prudent to purchase within a four-hour drive of your principal residence so you can conveniently monitor and/or maintain your property. This is just a general guideline, of course. Reasons for Sale One of the important factors to determine is why the property is for sale. Maybe the vendor knows something you don't, which will have a bearing on your further interest. On the other hand, maybe the vendor wants to move to a larger home or downsize to a smaller home or condo, plans to separate or 82 Chapter 3 divorce and move out, has lost employment, needs to relocate for a job, or is seriously ill or incapacitated. (A more detailed discussion of a vendor's motives is covered in Chapter 9: Negotiating Strategies.) Where to Find a Property for Sale There are some preliminary considerations you need to work through before starting your search. First of all, have a strategic plan: Be clear about what type of real estate you want and which area you are interested in; this will save time and stress. (Chapter 1 dealt with determining your real estate strategies.) Target specific geographic area or areas. This makes your selection process much simpler and gives you an opportunity to get to know specific areas thoroughly. Obtain street maps of the area as well as a zoning map from City Hall. Know the price range that you want to buy in, based on your available financing and real estate needs. Determine the type of ideal purchase package that you want (e.g., price and terms) as well as your bottom-line fallback position. What is the maximum you are willing to pay and the most restrictive terms that you can live with? Make sure that you don't compromise your own position. Do comparisons and shortlist choices. That way you can ensure you get the best deal, in comparative terms. Be realistic in terms of your purchase conditions in accord with the current market situation. Many people fantasize about buying investment real estate for 20% or more below the fair market value and keep searching for this elusive purchase. The reality is, such a purchase could be very difficult to find. Don't wait for mortgage rates to go down before looking. Higher mortgage rates generally mean less demand in the market and therefore lower prices and more negotiating leverage for the purchaser. Conversely, lower mortgage rates generally mean more demand in the market and therefore higher prices and less negotiating leverage for the purchaser. These are guidelines only. The key factor is to buy at the right price, taking all the factors outlined in this book into consideration. If mortgage rates come down, you can renegotiate a lower mortgage rate with or without a penalty, depending on the mortgage you originally negotiated. Finding and Evaluating the Right Property 83 Remember, the location of a property is very important, especially for a principal residence. Location is, of course, also important for investment property, but it has to be balanced against overall investment goals such as tax benefits, appreciation, resale potential, and net revenue. Consider the issue of distance between your prospective investment property and where you reside. It really depends on several factors, such as type of investment, size of investment, and amount of management required. If it is a smaller investment, you may want to be close to the property so that you can visit it, manage it, attend to any problems, and show vacant suites. If it is a larger investment, you may consider hiring a resident manager or professional management company. In this latter situation, you could live a considerable distance away, even in a different province. There are various methods of finding out about real estate for sale. Here are some of the most common approaches. Real Estate Agent An experienced real estate agent is an invaluable asset. A realtor can save you time, expense, and frustration, and provide advice and expertise. Remember that the vendor pays the real estate commission whether the agent is a listing or selling broker. (Refer to Chapter 6: Understanding the Legal Aspects for a discussion of real estate listing agreements. Refer to Chapter 4: Selecting Your Advisory Team for a discussion on selecting realtors.) There are many advantages to using realtors. You can use their services to source properties listed on multiple or exclusive listings, or for property being \"sold by owner.\" You can also use them to contact owners of property who wish to sell a property, but who haven't listed it yet. The advantage of using realtors to source unlisted properties is that they might be able to negotiate a better deal for you than you could get yourself. There are strategic benefits to having an agent present the offer and negotiate on your behalf. Frequently, the owner will agree to pay a commission to the realtor if you buy, although the commission in an un-listed sale would generally be less. This is because the realtor has not had the expense of time or advertising in actively promoting the listing. Alternatively, you could arrange to pay the realtor a negotiated fee if he or she arranges a sale at a price attractive to you. If you use a realtor to assist your search, be loyal to him or her if you purchase the property. On the other hand, if the realtor is disinterested, then find Chapter 3 84 another. Give your agent a list of your requirements so the agent can refine the search for you. For example, if you want to buy a house, give the agent information such as: price location style of house age of house number of bedrooms square footage basementon-basement self-contained suiteo self-contained suite lot size exposure of lot fireplace en suite zoning. Multiple Listing Service The Multiple Listing Service (MLS) is an excellent source of information. You can research most of the information on the MLS Web site at www.mls.ca. However, a realtor would be able to assist you in your historical or comparative research by accessing the MLS database, which is not accessible to the general public. If you are looking at an MLS book or Web site, look for specific factors that will give you clues as to vendor motivation or the appropriateness of the property. This could assist you in negotiating a lower price. For example, look for the exact area, when the property was listed (how long ago), if it has been relisted, whether the property is vacant, if any price reductions have occurred (for how much and when), and whether there has been a previous collapsed sale. Also look in the remarks/comments section in the MLS listing book. For example, it could say why the property is for sale, such as foreclosure action, order for sale, relocation, the vendor bought another house, etc. All this information is important. Newspaper Ads Look in the classified section of your daily or community newspaper under \"Houses for Sale,\" \"Homes for Sale,\" \"Condominiums for Sale,\" \"Revenue Property for Sale,\" or \"Apartments for Sale.\" The weekend section tends to have the most listings. The Monday classified section has the least number of listings. Because Finding and Evaluating the Right Property 85 fewer people read the Monday section, that could mean more opportunity for you. Ignore the harmless sales puffery. Many ads are designed to entice you with the impression the owner is anxious and therefore imply that you may be able to get a better price. This may or may not be the case. Watch for ads that may imply that the owner has a time pressure, such as \"estate sale,\" \"owner transferred,\" or \"foreclosure sale.\" Also, look in the special real estate newspapers that are available free and come out weekly in many major Canadian cities. Develop an organized system when reviewing ads. For example, you could circle with a coloured pen those ads that interest you, clip them out, and staple them to an 81/2" 11" sheet of paper, and store them in a binder. Date the ads and write the information in summary form when you speak with the owner. Your checklist of questions will keep you on track so that you have information for comparative purposes. Keep the ads for interesting properties for six months (if you are still looking), so that you can track the property to see if it has gone down in price (if it is still on the market). The types of ads described could be listed by a realtor or \"for sale by owner.\" Clearly, the suggestions relate more to a \"for sale by owner\" research approach. If it is listed, you will go through a realtor. Putting Ads in Newspapers You may wish to locate property owners who have not yet put up their property for sale, or who are selling it themselves. One way is to insert an ad in the \"Real Estate Wanted\" or \"Property Wanted\" section of the daily or community newspaper in the area that you are considering. Be precise about your needs in the ad, or many people may waste your time phoning you for clarification. Develop a standard checklist of questions you will ask the callers. That will save you time and frustration. Get right to the point to obtain the information you need. Drive through the Neighbourhood As mentioned earlier, it is important to become familiar with the area you are interested in. Drive through the area regularly and look for \"For Sale\" signs, both properties listed with a realtor and \"For Sale by Owner.\" Note addresses, names, and telephone numbers, and other contact information. Direct Offer to Owner In the process of becoming familiar with a particular neighbourhood, you might see a property that is not currently for sale but whose owner might be 86 Chapter 3 interested in selling. Look for clues that the property is vacantuncut lawns, peeling paint, broken windows or fence, etc. Also look for signs that say \"For Rent,\" because that owner might be interested in selling. Once you have determined which properties might seriously interest you, you can find out who the owner is by doing a search in the local land titles office. The documents are on public record. You could do the search yourself or through a lawyer or realtor. You would also be able to discover other information in your search, such as when the existing owner bought it and for how much, the nature and amount of mortgage financing, and if there are any legal problems relating to the property such as liens, judgements, foreclosures, or power of sale. If you want to pursue it further, you could contact the owner yourself, or preferably have your lawyer or realtor contact the owner. Word of Mouth Tell your friends, neighbours, relatives, or business associates that you want to buy property, the type of property you are looking for, and the area you are interested in. They might hear of someone who is thinking of selling or see a property for sale in their neighbourhood that might interest you. Determining the Value of the Property One of the most important steps is determining the value of the property you are considering. In other words, how much should you pay for it? In theory, a property is worth whatever a buyer is prepared to pay for it. There are various appraisal techniques that you can use, and that are used by professionally qualified appraisers. In addition, there are rules of thumb that real estate investors often use with revenue property. These rules of thumb are guidelines only. There are limitations to some of them, in terms of their accuracy or acceptance. Appraising a property value is more an art than a science. Two pieces of property are seldom identical. When a professional appraiser writes a report, the estimate of value is given as an opinion, not a scientific fact. This is helpful to you as a basis for negotiation with the owner. Anyone can have an opinion as to value. The appraisal, though, is only as reliable as the competence, integrity, experience, and objectivity of the appraiser and the accuracy of information obtained. Real estate appraisal is only as reliable as the assumptions that are made. There are distinct benefits to having a professional appraisal. The main reasons for an appraisal would be to determine the following: Finding and Evaluating the Right Property 87 a reasonable offering price for purchase purposes allocation of the purchase price to the land and building (revenue property) the value of a property for financing purposes (your lender will require this) the value of a property at death for estate purposes the value of a property when converting the use from principal residence to investment (rental) use, or vice versa, which would be for Revenue Canada (CRA) capital gains determination purposes, unless you are exempt from this provision (more detail is covered in Chapter 7: Understanding the Tax Aspects) a reasonable asking price for sale purposes the amount of insurance to carry undertaking a feasibility study of a purchase preparation for a property assessment appeal preparation for litigation preparation for expropriation negotiations preparation for taxation records or appeal. There are several professional designations for property appraisers in Canada. They subscribe to uniform academic, professional, and ethical standards, and are regulated by their professional associations. The most common national designations are Accredited Appraiser Canadian Institute (AACI) and Canadian Residential Appraiser (CRA). There are other national and provincial appraisal designations as well as specialty appraisal areas, e.g., industrial and commercial. Check out the Web site for the Appraisal Institute of Canada at www.aicanada.ca. Here are some of the basic methods or rules of thumb that professional appraisers, real estate investment lenders, or homebuyers use. Even if you just use the market-comparison approach initially, you should be familiar with the other methods and their limitations, especially if you intend to invest in revenue real estate. Market-Comparison Approach This approach is probably the most easily understood concept for a first-time homebuyer or investor. It is also the most common approach that real estate 88 Chapter 3 agents use for single-family dwellings. In effect, it is comparison shopping comparing properties that are similar to the one you are considering. Because no two properties are exactly the same due to age, location, layout, size, features, and quality differences, you need close comparables to work with. Compare properties whose sale dates are as current as possible so that they reflect the same market conditions. To make more realistic comparisons when you determine prices of comparable properties, you may have to take into consideration such matters as the circumstances of the sale (e.g., forced sale due to financial problems, order for sale, foreclosure, etc.), special features of the property (e.g., flower garden, shrubs, arboretum, etc.), and location of property (view, privacy, etc.). The market-comparison approach lends itself to situations where the properties are more numerous; there are more frequent sales, so they are easier to compare. Condominiums, single-family houses, and raw land are the most common types of properties for which to use the market-comparison method. At least it gives you a general sense of the appropriate value. Refer to Checklist 1 and Form 9 in the Appendix as guides for comparing properties. Generally, when an appraiser is doing a market comparison, he or she compares recent sales of similar properties, similar properties currently listed for sale on the market, and properties that did not sell (listings expired). The limitation of the market-comparison approach is that similar properties may not be available for comparison in a particular situation. Also, it is difficult to know the motivations of the vendors of the comparable properties, so in some cases the sale price might not reflect the fair market price. For example, if you are comparing a condominium for sale against two other identical condos in the same complex that have sold very recently, the data will give you a fairly close comparison. You could calculate the cost per square foot of the two recent condo sales and compare these costs against the cost per square foot of the one you are considering. If that latter price is higher, you need to know why. Perhaps it has a better view, is on a higher floor, or maybe the previous owner made many interior decorating changes to improve the condo. The point is that the market-comparison approach does have its limitations and provides general guidelines only. If you are buying an apartment revenue property, some appraisers use various market-comparison approaches to determine value. Finding and Evaluating the Right Property 89 One approach is to calculate the average price per unit for comparison. For example, if the \"average\" price of comparables were $50,000 per apartment and the property you were considering had 10 apartments, the purchase price in theory would be $500,000. The problem with this price-per-unit rule of thumb is that it is probably the least reliable in determining the value of a revenue property. When the appraiser researches the area and prepares a list of comparable revenue properties, the following types of factors are, ideally, similar amenities, appearance, size, location, rent structure, condition, and dates of sale. The problem is that it is difficult to find similar comparables in apartment buildings that are reliable. There can be so many variables. The result in terms of estimated market value can therefore be artificial and unreliable. There are more reliable methods for estimating value that will be discussed later. Another approach to determining the value of an income property involves calculating the income per square foot of the building, and comparing this figure with comparable properties. To do this, you calculate the amount of income-generating square footage in the building (excluding square footage of common areas, hallways, and lobbies). Once you have this figure, you can divide it by the gross revenue from rents to end up with the income per square foot. This approach also has some of the limitations mentioned in the point above. Cost Approach This approach involves calculating the cost to buy the land and construct an equivalent type of building on the property you are considering with appropriate adjustments, and then comparing the end prices. If you calculate that the replacement cost is below market value, you might want to seriously consider the benefits of buying a lot and building on it, in terms of cost savings. This approach comes, of course, with its own advantages and disadvantages. There are various steps involved in arriving at a figure using the cost approach. Step 1 Estimate the land value, using the market-comparison approach discussed earlier. The sale price of similar vacant residential lots in the area should be determined, with adjustments made for such factors as use (zoning), size, location, and features (e.g., view). Chapter 3 90 Step 2 Estimate the cost to construct a new building that is comparable in square footage, features, and quality to the one you are considering. For example, a modest-quality construction could be $100 per square foot to replace, whereas a luxury-quality construction could be $200 per square foot to replace. Step 3 If the house you are considering is not new, you will have to calculate a depreciation factor, e.g., reduced value of the building, because it is wearing out over time. Calculating the depreciation adjustment factor depends on the building's condition, age, and estimated useful life. Estimated useful life means the point beyond which the building is not economical to repair or maintain. In effect, it would have no market value. If that is the case, you might be buying primarily for lot value and intend to tear down the building or substantially renovate it. A professional appraiser is usually required to calculate this depreciation factor. Step 4 To determine estimated property value, add the depreciated cost of the building (Steps 2 and 3) to the cost of the land (Step 1). For single-family houses and condominiums, the appraiser normally arrives at an estimate of value as of a certain date by adding the market and cost approach values, and dividing by two. An example of this will be shown below. Example of Estimate of Market Value This estimate uses market and cost approaches, which is the usual formula for evaluating properties such as houses and condominiums. If you were buying a revenue property (e.g., apartments), you would normally add on the income approach and then take an average of all three approaches. 1. Market-Comparison Approach Comparison of four similar properties whose prices were $150,000, $155,000, $160,000 and $157,500. Average price is therefore $155,625. Market Approach Estimate: $ 155,625 Finding and Evaluating the Right Property 91 2. Cost Approach Land 30-foot 150-foot lot = 4,500 square feet @ $10 per square foot $ 45,000.00 Value of improvements on land, such as shrubs, trees, fence, garden, tool shed $ 7,500.00 Construction of building is 1,000 square feet at $100 per square foot construction cost (new) was $100,000 Less 5% depreciation per year because building being purchased is two years old: $100,000 - 5% = $ 95,000 (Year 1), and $ 95,000 - 5% = $90,250 (Year 2) Therefore, depreciated value of building $ 90,250.00 Cost Approach Estimate: $ 142,750.00 FINAL ESTIMATE OF MARKET VALUE: $ 149,187.50 (MARKET VALUE IS DETERMINED BY THE FOLLOWING FORMULA: Market approach estimate of $155,625 plus cost estimate of $142,750 divided by two equals $149,187.50.) The limitation of the cost approach is that depreciation might be difficult to correctly estimate. In addition, construction costs vary, depending on location, supply and demand, and inflation. Again, the cost approach value is only an estimate. Income Approach This approach is the most common one used when estimating the value of income property. In practical terms, though, you will probably use a combination of all three approaches to determine the value of a revenue property. In addition, there are other rules of thumb for revenue investment property that will be discussed later. 92 Chapter 3 Basically, the income approach assumes that the value of the property is the present worth of the future cash flow that the property is expected to generate. For example, the property is worth X times its annual net operating income. As mentioned, the income approach cannot be viewed in isolation. It is important to use it in conjunction with the previous two approaches so you can consider factors affecting the overall investment climate, such as interest rates, taxes (municipal, provincial, and federal), rent controls, inflation, cost of land, cost of construction and materials, comparative property prices, and supply and demand (of tenants and competitive rental buildings). When you calculate the value of income property for your own investment purposes, be on the conservative and cautious side and use the lowest evaluation. Depending on the nature of the property, however, your investment goals, and the objective of the appraisal, one approach may be better than another. The most common income approach used by lenders and appraisers to determine a fair market value is the capitalization method. The purpose is to project the value of a property based on the amount, certainty, and length of time of future flow of income (income stream), and then placing a dollar value on that future income stream by applying a capitalization rate. The capitalization (or CAP rate, as it is commonly known) is a rate of return used to derive the capital value (total value) of an income stream. For example, the net operating income (also referred to as NOI), which is the amount remaining after all expenses of the property have been met but before taxes, is \"capitalized\" at a certain percentage (say, 10%) to determine a value of a property. If a building is producing an NOI of $30,000 and that is capitalized at 10% (or sometimes referred to as \"CAP rate of 10\"), then the fair market value would be $300,000. In other words, to achieve a CAP rate of 10%, you would have to attain an NOI of $30,000 in order to justify paying $300,000 for the income property. The formula just used is a common one and every investor should understand it. It is commonly known as the IRV formula, where the letters represent the following: I = Income or, more specifically, net operating income (NOI) R = Rate or, more specifically, capitalization (or CAP) rate V = Value or, more specifically, fair market value (FMV) The basic formula is as follows: I R V Finding and Evaluating the Right Property 93 As long as you know at least two of the three items in the formula, you can determine the third item by removing it from the formula and calculating out the remaining item; in other words, rearranging the components of the formula. For example, the values of I, R, and V can be obtained as follows: Net operating income (I) = CAP rate market value, or I = R V Example: If you are prepared to pay $245,000 for an income property and you want a 9.5% return on your investment, what net operating income would be required? Answer: Separate out the unknown factor and fill in the other two letters (factors) with the known information: I = R V = .095 (9.5%) $245,000 = $23,275 Therefore, you would need a net operating income of $23,275. Capitalization rate (R) =Net operating income divided by market value, or R = I V Example: A property generating a net operating revenue of $25,000 a year is priced at $220,000. What is the CAP rate on the investment? Answer: Separate out the unknown factor as you have done previously. R = I V = $25,000 $220,000 = 11.3% Therefore, the CAP rate is 11.3%. In other words, as an investor, you will earn 11.3% return on your $220,000 investment (ROI). Market value (V) = Net operating income divided by CAP rate, or V = I R Example: A property is to be capitalized at 11.5%. It has a net operating income of $16,000. How much can you justify paying for it if you want to obtain an 11.5% return on your investment (ROI)? Answer: Separate out the unknown factor, as you have done previously. V = I R = $16,000 .115 (11.5%) = $139,130.43 The most you could justify paying will therefore be $139,130.43. 94 Chapter 3 You can see the benefit of the IRV formula in terms of a quick analysis of the key factors. It is important to remember that the formula does not take financing or mortgages into account. All the results obtained are based on the assumption that the property is clear of all financing. The IRV formula is also helpful when comparing similar properties. When deciding what CAP rate to use for your investment purposes, remember your investment objectives and the degree of risk you are prepared to take. Ideally you will want at least a CAP rate of 10% (higher than that is better) in terms of your return on your investment. Different investors have different CAP rate criteria. The types of factors taken into account include the type of property (e.g., small or large apartment building); age (e.g., the older the building, the less future income can be derived from it in its present state); location (e.g., the closer the building to the tenant base, the better); and quality of tenancies (e.g., leases are preferable to month-to-month). As a rough rule of thumb, a lowrisk investment or area (or anticipated low inflation in the area) should have a minimum 8% CAP rate, a medium-risk investment or area (or anticipated medium inflation in the area) should have a minimum 10% CAP rate, and a high-risk investment or area (or anticipated high inflation in the area) should have a minimum 12% CAP rate. The greater the risk, the greater the premium you will want in terms of a higher CAP rate. Another method of estimating the approximate CAP rate value for a building you are interested in is taking the average of the CAP rates of comparable properties in the same geographic area. You can also contact a professional appraiser familiar with the area and type of income property, and request approximate CAP rates. Remember, if you can get a totally risk-free investment return from Canada Savings Bonds, Treasury bills, or term deposits of 6% (or whatever the prevailing rate would be at any given time), for example, you will want to buffer your risk by ensuring the overall income property package is attractive. (Refer to Form 8, which is an income approach worksheet, as well as Form 9 in the Appendix, which is an investment property analysis worksheet.) Percentage of Operating Expenses Once you start comparing various revenue properties in your area, you will see an average overall pattern in terms of the proportion of the various operating expenses relative to the gross income. In Canada, apartment-building expenses tend to be between 35% and 45% of the gross income. That can vary, of course, Finding and Evaluating the Right Property 95 depending on the circumstances. If you see that the percentage reflected by the vendor's information supplied to you is less than 35% or more than 45%, for example, you should thoroughly verify the data independently. You should also confirm the accuracy of the information. Some vendors can be less than forthright, in order to make the investment picture appear more attractive. If you rely solely on the vendor's information and it turns out you were misled because it was inaccurate or incomplete, you could lose a lot of money. Look for individual expense variances from the norm. For example, if the insurance cost is 2% when the norm should be 5%, then the building might be underinsured, and you will have to pay more in insurance premiums to protect your investment. If the property management fee percentage is lower than normal, the management company may not be providing adequate management, or is new and inexperienced and gave a low quote to get the contract. If the resident manager's costs are too low compared to the normal percentage, possibly the reason is that the costs are artificial. The real costs to hire someone if you buy the building could cost more because the owner's family is performing all the on-site management and not taking a fair market payment for the services provided. Again, refer to Form 8, which is an income approach worksheet showing the various categories of expenses, and Form 9, which is an investment property analysis worksheet. Before you make any final decision to purchase a particular revenue property, do a projected cash flow statement (Form 5 in Appendix), a projected income and expense statement (Form 6), and a projected balance sheet (Form 7). In other words, you need an accurate idea of what you can make from the property based on realistic projections. The initial analysis you did of the property just dealt with the current situation. Realistic projections will tell you if the current financial analysis will improve or worsen over time. Of course, your professional accountant should thoroughly review all the financial statements of the revenue property for inaccuracies, inconsistencies, shortcomings, and false or unrealistic assumptions. Gross Income Multiplier You may hear of real estate investors who use the gross income multiplier (GIM) formula. You should understand how it works. It is an inaccurate method of determining a property value, not only in absolute terms, but in relative terms to other properties. You may wish to use it, but only in combination with the other more realistic rules of thumb described. Chapter 3 96 Investors use different GIM multipliers, depending on their investment objectives and other factors. For example, if an investor uses a GIM of 6, that would mean that the annual gross income (say $40,000) would be multiplied by 6 to determine the maximum value of the property. In this example, it would be $240,000. The problem is that the GIM method does not take into account such critical factors as mortgage payments or operating expenses, so the formula is rather artificial. Say the average range of operating expenses for the type of income property in the geographic area you are considering is 35% to 45%, as discussed in the previous section. The GIM formula does not take into account that the property you are looking at could have costly operating expenses, at 70% for example. Therefore, the GIM of 6 would arrive at a greater value than the property is really worth. Also, you could be locked into a long-term, high-interest closed mortgage with a six-month interest penalty or cancellation. Current mortgage rates could be 4% lower, for example. The GIM does not reflect these factors. On the other hand, the property could be very efficiently operated and have operating expenses of 30% and a long-term lowinterest mortgage. The property could therefore be worth more than six times the gross income. Remember, from an income property purchase viewpoint, the lower the GIM, the better. The GIM basic formula is: Gross income multiplier = Market value Effective gross income or GIM = MV EGI or MV = GIM EGI or EGI = GIM MV Effective gross income means the actual current income, not a projected or potential income. Another application of the GIM usage is to determine the amount of time it would take to pay back the investment. The GIM calculated tells the investor how many years it would take to recover the total investment costs (purchase price) if all the gross income were allocated to pay off the purchase price. Again, this formula has limitations, of course, because it is rather artificial in that you would, in reality, be paying operating costs from the gross income. It is just another yardstick to use. For example, if an investor is considering an investment with an asking price of $700,000, and the effective gross income in the first year is $100,000, the GIM would be 7: GIM = $700,000 $100,000 = 7 Finding and Evaluating the Right Property 97 Therefore, in theory, if all the gross income were used to pay for the original total property cost, it would take seven years to recover the total cost of the investment. Net Income Multiplier The net income multiplier (NIM) is a more reliable way to determine the number of years it will take to recover the initial investment outlay from the future net income from operating the revenue property. Conversely, the formula will help you determine the maximum price an investor would be prepared to pay for the property. Net operating income (NOI) is a frequently used term in investment real estate. It is basically income produced by the property after all operating expenses and allowances for vacancies have been removed, but before mortgage payments. For example, if you apply an NIM of 10 as your investment formula, and the NOI of a property is $30,000, you would place a maximum value that you would pay of $300,000 for the property. The formula is: MV = NIM NOI MV = 10 $30,000 = $300,000 The NOI formula is more accurate because all the variables in the building operation, such as rental income, vacancies, and operating expenses, have been accounted for. The only variable that has not been accounted forbecause it varies, of courseis the cost of mortgage financing. This is the one factor that can affect the accuracy of the NIM rule of thumb, in terms of the bottom-line income. For example, what may appear to be a good investment because of the NOI would not be so attractive if there is a high-interest long-term closed mortgage with a large penalty clause. That is why you have to consider the limitations of the NOI multiplier formula and make allowances for it. The basic formula for determining the NIM is as follows: Net income multiplier = Market value Net operating income or NIM = MV NOI For example, if an investment property has a purchase price of $600,000 and the net operating income is $60,000, the NIM multiplier would be 10. This number is also used for payback calculation purposes; for example, it would take 10 years to recover the total investment cost if all the net operating income was 98 Chapter 3 applied for that purpose. Conversely, the overall capitalization rate is the reciprocal of the NIM (10)that is, 10%. In other words, you would be receiving a return of 10% on your initial purchase price outlay relative to the NOI. Internal Rate of Return The internal rate of return, sometimes referred to as the IRR, is a calculation that some investors use to determine how much they will make annually on their investment. There are many factors that have to be taken into account to increase the accuracy of the results; e.g., mortgage principal reduction, anticipated property appreciation, anticipated inflation, and after-tax cash flow. Realistically, when you are projecting your final return on your investment upon sale, that is your true net profit. You also have to take into account such additional factors as the amount of capital gains tax on sale of the property, closing costs on sale, legal fees, real estate commissions, and mortgage penalty if there is a closed mortgage at the time of the sale. In addition, you have to calculate any projected interest you might be able to earn on the excess cash flow, if it is a positive cash flow. Such factors as your projected personal income tax rate also have to be estimated. This can vary, of course, but for projection purposes you have to make certain assumptions, such as percentage of appreciation and inflation. Most IRR calculations are done on a computer spreadsheet program. At the bottom of the printout you will see the IRR percentage. For example, the IRR might show an annual return of 25%. You might intend to keep the investment for five years and sell it, assuming the market conditions are favourable. Normally, the IRR figure would initially exclude the inflation factor. You will also want a calculation with inflation projected to make sure that your intended investment, in real value of money terms over time, exceeded inflation as much as possible. It does have some limitations as well, in terms of assumptions. As the IRR calculation is initially based on estimates, the IRR itself is only an estimate of the expected return on your investment capital. Your professional tax adviser can tell you more. This section has covered some of the most common types of techniques for establishing the value of a property purchase. There are many others that exp